Markets Without Guardrails

First, the bond markets are showing strains. For instance, both investment-grade
and junk-rated companies are finding it more difficult to issue bonds. To put
this in today's context, the momentum money that has pushed asset prices up
since the spring of 2009 assumes, or believes, that governments will do whatever
is necessary to sustain the upward march. Now there are doubts.

It looks as though institutions may be withdrawing funds from the global banking
system as worries of European bank solvency rise. Recent spikes of interbank
lending rates (such as LIBOR) suggest this.

The so-called recovery has been artificial. Pete Briger of Fortress Investment
Group "poured cold water" on a recent private equity meeting in Boston, the
SuperReturn U.S. conference. According to the Wall Street Journal, "the
private-equity princes" basked until Briger spoke, when he stated what everyone
in the room knew. He "said the improved environment is, in effect a charade,
with everyone from central banks to large financial institutions 'in cahoots' to
boost lending markets and consumer confidence." [The Journal's quotation
marks, my italics.]

The second change is the rising volatility across markets, from currencies
to stocks. To some degree, the greater frequency of stock markets rising or
falling 2% or 3% in a day is attached to tighter credit market conditions.

A shakeout does not require a reduction of funding. "Charades," also known
as bubbles, need ever greater amounts of funding to stay in place. If the pace
of funding slows (for example, from a 10% to a 5% rate), the markets are apt
to snap.

Prices in the stock market, for instance, flap around as computers decide
whether the institution should be a buyer or seller at a certain level. This
has led us into the unknown, as explained by the Financial Times: "An
explosion in trading propelled by computers is raising fears that trading platforms
could be knocked out by rogue trades triggered by systems running out of control."

This is a great worry, but nothing so nefarious is needed to ally a stock
market crash. The buy-and-hold investor is in a lonely position. Only 3% of
trading was by retail investors in U.S. equity markets during 2009. (For
more on our perverted markets, see Aucontrarian.com "blog" Should Investors Boycott the Stock Market?)

We have on our hands a deep-sea oil rig with the safety features for skimming
oil off the water's surface. The technology for trading, such as described
by the Financial Times, has not been matched by new technology to slay
the monster, if necessary. There were such checks-and-balances in the days
when stocks were traded on the floors of the exchanges.

At a Grant's Interest Rate Observer conference in November 1999, one
speaker was not concerned about the stock market. (For those who were still
in school, the Nasdaq had risen 150% over the previous 13 months.) One reason
this speaker cited was "strong central bank leadership." Another speaker, Michael
Steinhardt, did not think the Fed's leadership would be worth much when it
was needed most. Steinhardt had started on Wall Street in the 1960s, the "Go-Go
Years." Few investors had gone-and-got as profitably over the prior three-and-one-half
decades as Steinhardt. He spoke about Wall Street's abandonment of controls,
leadership and responsibility:

"The liquidity safeguards, historically, were the specialists' books, the
retail system, and the institutional liquidity providers in the major brokerage
firms. They were the mechanisms that the stock exchange itself had provided,
and they were all structured for a system where trading was a very, very small
fraction of what we're seeing today. Now there are no specialists' books; there
is no serious liquidity provided by brokerage firms; and the trading mechanisms
of the exchange are hardly relevant to the sorts of volumes that exist today.
So yes, the Federal Reserve, if you define that broad context of liquidity
in a financial sense, does still exist, but in a securities market sense, none
of the former ones do."

The average buy-and-hold investor probably did not realize how the institutional
framework was constructed to generate a harmonious flow of buy-and-sell orders
and to protect the market from abuses. Now the institutions perpetrate the
abuses and the guardrails no longer exist.

The "strong central bank leadership" was absent once the Nasdaq commenced
its 78% collapse in March 2000, when the bubble had reached a level that no
liquidity safeguards could have prevented. During the plunge, central bank
leadership layered the world with paper in an effort to pump economies back
up.

Now, that paper cannot be paid back. Since 2007, the world financial system
has suffered periodic waves of deleveraging, during which times central bank
leadership could not compensate for the discarded institutional mechanisms
that had contained disruptions.

As Pete Briger of Fortress Investment Group said, the central banks and large
financial institutions are "in cahoots." Their objective, "to boost lending
markets and consumer confidence" is to draw the unsuspecting into markets.
Beyond that, the institutions trade now to make money for themselves. Such
notions as leadership and responsibility are gone with the wind.

Chances are good that volatility will keep rising until we reach a sharp market
break. In simpler days, receding liquidity and less stable markets under bubble
conditions meant "crash." This is still the likely course, but governments
know asset prices are the hedgerows that shield fallow economies from view.
Governments want to preserve the façade. They will do what they can
to push prices up. Speculators who see governments re-open vast credit lines
(as they did in 2008) will probably reverse course in a fit of panic buying.

It looks, though, that central banks will respond after the fact rather than
act preemptively. The Federal Reserve has reinstituted swap lines, but even
that decision was in reaction to a problem the markets had already identified.
Government will inflate, but probably after steep declines across markets.

Sheehan serves as an advisor to investment firms and endowments. He is the
former Director of Asset Allocation Services at John Hancock Financial Services
where he set investment policy and asset allocation for institutional pension
plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and
quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S.
Naval Academy. He is a Chartered Financial Analyst.